Ray Jay: ECO Index at All-Time Low – Is There Hope for Clean Tech Stocks?

I don’t pass along much Equity Research these days, but given the crossover interest in clean tech — it fits both VC and public investor profiles — this note from Raymond James’ U.S.-based Equity Research Energy team deserves a read:

* The creators of the WilderHill Clean Energy Index (ECO), the most closely tracked index encompassing the entire clean tech sector, surely did not envision in August 2004 that their index would be duking it out with banks for the title of worst-performing equity sector. Having peaked at nearly 300 in late 2007, the ECO collapsed amid the financial meltdown in 2008 and never fully recovered. As of yesterday’s close, it reached an all-time low of 51.15, down 52% year-to-date.

* What happened? At the outset, we hasten to underscore – as we’ve done before – that broad-based observations about clean tech as a whole are not especially meaningful. The fundamentals of different subsectors – solar, wind, biofuels/chemicals, smart grid, etc. – vary widely, and within each individual subsector naturally there are both winners and losers (more on that later). That said, here is the big picture. Obviously, there is currently a “de facto” bear market, and in this climate, clean tech stocks are out of favor as part of the risk aversion/flight to quality trade. But let’s not focus on just the last two months. Over the past three years, most clean tech companies have been torn between two opposing forces. On the one hand, there is no question that the underlying economics are getting much better – in some cases, dramatically better. This is sometimes a function of rising conventional energy prices [Brent crude oil is still near $100/Bbl and Asian liquefied natural gas (LNG) near $15/Mcf, despite the painful economic climate], but more often than not it reflects ongoing reductions in costs of the alternatives. This includes, among other things, photovoltaic (PV) modules (average prices down ~30% year-to-date), wind turbines (more scalable, especially for offshore projects), and cellulosic biofuels (finally approaching commercial viability). All this drives greater levels of adoption. On the other hand, this same “mainstreaming” and scale-up of clean tech also means that many of the industries are becoming truly commoditized. PV is the textbook example here. In mid-2008, a typical PV manufacturer would earn a 25% margin (about $1.00/watt) on a selling price near $4.00/watt. Today, they’d be lucky to get 15% (about $0.18/watt) on a price of $1.20/watt – a decline in profit per unit of 80%! Similar observations can be made about wind turbines, advanced batteries, and so on. China’s growing dominance in many kinds of clean tech manufacturing helps explain the commoditization, but don’t forget the role of Silicon Valley and other U.S. R&D hubs, whose innovators are driving the technological improvements that overseas companies are all too happy to buy (or occasionally acquire in, umm, other ways).

* Why selectivity matters. Although the basic trend described above – robust sales growth vs. ever-slimmer unit margins – is something that affects just about everyone in clean tech, it certainly does not mean that everyone faces the same competitive landscape. The global PV glut, for example, is unique in its severity among the clean tech subsectors. While that’s partly due to ongoing policy changes on the demand side of the equation, namely in Europe, our view is that the main culprits are found on the supply side, including but not limited to China. As companies continue to chase market share with reckless abandon, this inevitably leads to margin compression – it’s how supply/demand works. Within PV, of course, high-cost producers (e.g., Energy Conversion, down 89% YTD) are faring worse than the cost leaders (e.g., First Solar, down “only” 56% YTD). Companies whose products are less susceptible to commoditization, such as GT Advanced (down 27% YTD) in solar and Echelon (down 34% YTD) in smart grid, enjoy a wider “moat” around their business. However, proprietary intellectual property is no guarantee of success, as American Superconductor (down 88% YTD) found out the hard way after its main Chinese customer allegedly stole trade secrets. As a general premise, companies with direct leverage to oil – i.e., biofuel and other alternative fuel companies – are finding it easier to deal with the commoditization, since they are competing less against each other and more against a commodity that is in a secular upcycle (despite the daily volatility). Put simply, the world does not have a problem with not enough electricity, but the oil market is set to be increasingly supply-constrained in the future. This largely explains why we are currently recommending a majority (four of the seven) of the fuel stocks we cover (including our only Strong Buy – Amyris) but only five of our 15 power-related stocks.

MRM